Category Archives: systemic risk

The Wall Street Journal ran a story last week about Citigroup and Deutsche losing money on the oil hedge they sold to Mexico. The article talks of a loss totaling $5 million on a put sold for a premium of $450 million, so, in the grand scheme of things, this is not a big matter. However, it does raise an interesting puzzle in light of the Volcker Rule’s prohibition against proprietary trading.

Matt Levine over at Bloomberg does a nice job of dissecting what the banks are doing in the deals with Mexico. It’s part intermediation – taking a portion of the oil price risk from Mexico and reselling it through the oil futures market. But it’s also part acting as a principal – taking another portion of the oil price risk from Mexico and putting it onto their own balance sheets.

Are they allowed to do that – put the oil price risk onto their balance sheet? How is that different from proprietary trading? If Mexico weren’t involved, and the other side of the trade were a hedge fund, would that be any different, as far as safety and soundness is concerned?

Matt Levine thinks the story is a nice example of the banks doing their job. Sure enough, it’s a job that needs being done. But is it really the job of the banks to warehouse oil price risk? It may be socially useful, it may be a valuable financial activity, but it’s not an activity that belongs on a bank balance sheet. Levine’s column reflects how hard it is to get away from the old mentality in which banks think their job is to sell their balance sheet. The problem is, of course, that it isn’t their balance sheet that they are selling. It’s the taxpayers’.

The U.S. derivatives watchdog on Monday chided the industry for providing gappy data on the $630 trillion market… “I do want to get away from the handholding,” said Vincent McGonagle, the CFTC’s head of the Division of Market Oversight. “It is clear that there are issues where parties are not reporting,” he said.

What is he talking about?

I’m guessing that this is an example. ICE Trade Vault is a Swap Data Repository for commodity products, including financial power. In addition to running its data repository, ICE is a lead platform for trade in these products. According to data compiled by one of its platform competitors, Nodal Exchange, and provided to the CFTC’s Division of Market Oversight, the data feeds from ICE Trade Vault lack some of the most pertinent information about transactions:

…of the 33,030 financial power transactions reported by ICE Trade Vault in 2013, we found that 21,054, or 64% were listed as “exotic” and lacked basic transaction information such as the unit of volume and the product transacted. Furthermore, only 11,973 transactions, or 36%, of all financial power transactions reported by ICE Trade Vault contained any price information.

We were also dismayed to see that for even the relatively well described transactions denominated in Megawatt Hours (MWh) reported by ICE Trade Vault, the vast majority (11,214 of 11,893 transactions, or 94.5%) had, at best, only a generic region or Regional Transmission Operator (RTO) or Independent System Operator (ISO) identified. We believe this lack of specificity is largely unwarranted. For example, many transactions reported by ICE Trade Vault simply show “PJM”, a Regional Transmission Operator covering all or parts of 13 states plus the District of Columbia. However, on ICE Futures U.S., ICE offers futures contracts covering 13 distinct zonal locations and four hub locations within PJM, providing a ready basis for more specific locational reporting for ICE Trade Vault as well. Financial power information is really only useful if it conveys what product is traded (specific power location), at what price, and for what volume. This information is available on only 607 of the 33,030 financial power transactions, or 1.8%, as reported by ICE Trade Vault.

Trade reporting is the law, but there is obviously a long way to go before its a reality.

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What are the costs and benefits of the reform of derivative markets now taking place? A report released last week by the Bank for International Settlements (BIS) pegged the central estimate of the benefits at 0.16% of annual GDP.[1] With US GDP at something more than $15 trillion, that’s $24 billion annually. For the OECD as a whole, the figure is nearly triple that.

Approximately 50% of the benefits are due to the push to central clearing. Continue reading →

The issue came up yesterday when Fed Chairman Ben Bernanke testified before the Senate Banking Committee. Senator Elizabeth Warren cited a Bloomberg report that put the number at $83 billion to the 10 largest U.S. banks. The Bloomberg figure is extrapolated from the finding of an IMF study that the backstop provided to banks lowers their cost of borrowing by approximately 0.8 percentage points.

Matt Levine at Dealbreaker makes the provocative claim that “The Too Big to Fail Subsidy is Negative Sixteen Billion Dollars”. This comes in the second round of Levine’s tit-for-tat with Bloomberg. His original critique started off with a reasonable and incisive drill down into the numbers.[1] Now, after an effective rejoinder by Bloomberg, he abandons the two main points from his original critique and substitutes new ones.

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Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross.[1] Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.

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When a bank makes a loan to a business it assumes some risk that the loan will go bad. Regulators, when they do their job, demand that the bank estimate that risk and hold capital against it. That’s safe and sound banking.

What if a bank embeds the same loan inside a derivative it sells to the business? Should the regulators treat that credit risk the same and demand that the bank estimate that risk and hold capital against it? Six U.S. Senators say “no.” They want bank regulators to turn a blind eye to credit risk so long as that risk is packaged inside an OTC swap. So much for safe and sound banking.

All American businesses suffer when the U.S. financial system is made unsafe and unsound. Following on the Dodd-Frank Act, banking regulators last year proposed a sensible rule finally requiring banks to properly recognize the credit risk embedded in the derivatives they sell. That’s safe and sound banking, and if this country can find its way back to a safe and sound banking system all of America’s businesses will benefit.

The proposed bill seeks to reverse course, directing bank regulators to turn a blind eye once again to obvious risks. It’s a seductive proposition. With a stroke of a pen, the Senators believe they can save a few businesses the costs associated with this credit risk. But no act of law can actually erase the credit risk and the associated cost. The proposed bill only encourages more unsound trading and the accumulation of unaccounted for risk. For a short while, certain businesses will benefit by not having to pay full fare for the risks they add to the banking system. It’s always good while the party lasts. But, in the end, we all lose.

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Many Eurozone banks are going through huge deleveraging: they are selling their portfolios of loans to hedge funds, reducing and cutting revolvers to corporations, and shortening the overall maturity of their exposures. Faced with higher capital requirements as they experience melting equity values, and unable to raise funds from the US money market, European banks are left with no options but downsizing and help from the European Central Bank.

The banks’ deleveraging is paralyzing the European economy. Even healthy borrowers can’t be certain they’ll have the loans and lines of credit necessary for their regular operations. Many are going capital light: cancelling investments, shrinking working capital and selling non-core assets. Banks’ deleveraging has fostered a downward spiral amplified by institutional and retail investors dumping the stocks and bonds of banks and bank dependent borrowers. This is particularly nasty for the Eurozone, given the role banks have traditionally played in funding European firms.

New forms of intermediation are being developed. The most vigorous are via internal capital markets. Holding companies are tightening their grip over funds available at their subsidiaries—even when these are exchange listed companies—and are playing a much more prominent role in the allocation of funds.

A few large corporations are going beyond that and creating their own banks to make up for the vacuum created by the banks disappearing from the funding scene. Having a bank allows these corporations direct access to funds from the ECB, and enables them to store their excess liquidity in-house, instead of in deposits at outside banks that may be vulnerable to runs. The European aerospace firm EADS is considering doing just that. EADS’ bank could be the financial center of a large network of entities with business relations with the corporation, each with access to funds and able to deposit funds with EADS bank. If one counts EADS’ suppliers and major customers, as well as the suppliers of EADS’ suppliers and all their employees combined, that could be a very large bank indeed.

Out of necessity, the European Keiretsu is born!

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One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs. They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

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Speaking at GlaxoSmithKline’s annual results presentation last week, CEO Andrew Witty disclosed some of the strategies the company is employing to manage the risk posed by the Eurozone debt crisis:

We sweep all of our cash raised during the day out of the local banks and send it to banks here in the U.K. which we think are robust and secure. … We don’t leave any cash in most European countries. … And we’ve done that with a huge focus on getting paid. Like all things, if you focus on it, then eventually you do get paid.

GSK is not alone. According to the WSJ, Switzerland’s Novartis changed the incentives for its sales force in countries with significant debt issues, to collect the cash, not just generate the sales and put receivables on the company’s balance sheet. And Vodafone moves cash out of Greece every evening to guard against an exit from the euro, according to its CFO Andy Halford.

In some earlier posts, we have described some of the risk mitigating strategies by companies doing business in the Eurozone–here, here and here. The case made public by the CEO of GSK shows that companies also take precautionary actions by moving money across borders and between banks, as well as by taking steps to claw back money owed them by clients in financially distressed economies. Racing cash out of troubled zones is often done by multinationals operating in third-world countries. What is new is the use of that in first-world Europe.

One might ask whether this is a good way to actively manage risks, since it appears that by cutting funds to these countries companies like GSK are making the crisis worse and increasing their own risks of doing business.

Asked why GSK has taken these steps, Witty replied:

There was a period when things looked more worrying. The action that the [European Central Bank] took over the last six months has clearly had a very positive effect on bank liquidity and confidence. But there was a period last year when every day you were getting a phone call about Bank A, B or C which was perceived to be about to go or there were risks or there was anxiety about different banks in different countries. And we did a very comprehensive review about which banks we thought were the strongest and which weren’t. We moved our cash accordingly.

Witty’s remarks highlight the problem of bank (or country) runs. Whether GSK stays or leaves, it matters little, for if others leave the system collapses. The only way to avoid failure is if everybody stayed, but this is impossible to coordinate when each suspects that the others might leave. Such belief is by itself sufficient to bring down the system. Thus, the role for Leviathan, in Witty’s words impersonated by the ECB, and its actions to provide liquidity and confidence.

One final remark: When asked what the hedging strategy is with the money brought back daily to the U.K., Witty replied:

Remember that we pay our dividend in sterling so actually bringing the cash back to the U.K. is not a bad thing anyway because we always have use for sterling-denominated resources, so it’s really not an issue for us.

Surely that can’t be the whole story, for Witty understands that there are many ways to hedge exchange rate risk. The real problems are the concern over counterparty risk (banking freeze) and having money locked in a country that might fall off the cliff and impose capital controls. Witty still remembers an emerging markets crisis where the “general manager took bags of money to people’s [GSK staff’s] houses”.

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About this blog

We use this blog to discuss with our students issues in risk management for non-financial corporations. The blog addresses interesting events in the news, as well as advances in financial analysis. We have made the blog public to encourage valuable contributions from former students, colleagues and others in industry, government and academia.

The content of the blog is closely aligned with the material in our lecture notes on Advanced Corporate Risk Management (MIT course 15.423). A website with the notes and associated materials will be coming soon.